Incorporating a proper risk management plan into your CFD trading strategy is the single most important aspect of CFD trading. Risk management entails determining the amount of money that you wish to allocate to each trade to make sure that you can continue trading should you sustain a loss on the position.
Trading CFDs with no proper risk management strategy can expose you to excessive risk. As an example, in the event you allocate a significant portion of your trading resources to a trade with no proper risk management strategy, you put all your trading capital in danger, meaning that if you sustain a loss you will no longer be in a position to trade. Losing your whole capital base can force you out of the market and you will not even have the opportunity to regain your losses.
The most common form of risk management is trade sizing, this is also known as the fixed dollar trade size model. In this example an equal quantity of capital is used for each trade.
For example, for those who have $100,000 to invest, you’ll need to figure out just how much to put into the trade. To work this out you would simply divide $100,000 by the cost of the CFD. If the last traded price of the CFD was $8.50 you would divide this by $100,000 to work out the amount of CFDs you can buy. In this instance the number would be 11,764.
In order to work out the amount of risk involved in the trade you’ll have to determine just how much you can afford to lose if the CFD move against you and set your stop-loss at this point. This is also called the stop-loss distance, which is the distance between the entry and stop-loss price.
For example, if your stop-loss price is $8.00 and entry price was $8.50, this means that your stop-loss distance will be $0.50. If you have 10,000 CFDs your risk would be 10,000 multiplied by $0.50 or $5,000. In this instance your risk will be $5000, which equates to the amount that you could lose should the position move against you and you get stopped out.
It is also important to factor in the cost of commission and any financing costs that you could have incurred from holding the position overnight.
In the fixed dollar trade size model the number of CFDs which you buy and sell every time will not always be identical, this is because the stop-loss size will vary depending on the risk appetite you have on the trade.
An additional type of risk management is compounding, which means as your trading account balance increases, you can open bigger positions.
For instance, if you have a starting balance of $100,000 and you have determined that you could afford to have 10 trades open at any given time, as your trading account balance grows, you will be able to take on bigger trades. This approach can easily be used up to a point when your draw down gets too large for your liking and risk appetite.
It is also important to note that if you are trading a CFD that has liquidity issues, you may get to a position where your trade sizes are too great, as such you will have to take smaller positions.